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The Big Easy Inc
The Big Easy Inc. target capital structure calls for 30% debt, 10% preferred stock, and 60% common equity. It has outstanding 25-year noncallable bonds with a face value of $1,000, a 9% semi-annual coupon, and a market price of $1,187.66. The tax rate is 40%. The company's preferred stock currently trades at $65 and pays a $5 annual dividend per share. The company's common stock, on the other hand, currently trades at $35 a share and just paid $4.56 annual dividend per share. The dividend is expected to grow at a constant rate of 3% a year. In addition, the risk- free rate is 6%, the average return on the market is 10%, and the firm's beta is 1.5. Given the following information, answer the following questions: What is the flotation cost adjustment? What is the cost of external equity? Calculate the WACC if the common equity comes from retained earnings. Calculate the WACC if the common equity comes from new stocks. »If the company is considering the following capital budgeting projects: Project Size Rate of Return A SIM 13% B $2M 12.5% ? $2M 12% D $2M 11.9% E SIM 11% F SIM 10.56% G SIM 10% Which set of projects should be accepted?
Expert Solution
a)Floatation cost adjustment=It is important to understsnd floatation cost first
Floatation cost=whenever we issue new common stock a percentage of cost is f=gicen to brokers it is called floatation cost it is normally adjusted from the rate of return
Now using Dividend growth model
Ke=(D1/p)+g
With floatation =[D1/p(1-f)]+g
This gives Ke
Now whenever floatation adjustments are there Adjusted factor=Adjusted discounted cash flow-Pure discounted cash flow
Hence cost of equity=Ke+Adjustment factor
(it is usually ignored when calculating WACC)
Step2
b)Cost of equity
USE CAPM
Rf+b(rm-rf)
6%+1.5(10-6)
6%+1.5(4%)
12%
Step3
Calculation of cost of debt
Kd and prefeered stock and equity
|
Rate (NPER,PMT,-PV,FV) |
|||
|
Kd cost of debt |
Use formula rate on excel |
=RATE(50,45,-1187.66,1000) |
3.6746% After tax 4.49% (please refer the working below |
|
Cost of preferred stock (kp) |
Formula =dividend/current market price |
5/65 |
7.69% |
|
Cost of equity Ke |
Dividend growth model (D1/P0)+g D1=4.56(103%)=4.6968 |
(4.6968/35)+3% |
16.42% |
For working on excel for kd
When semi annual payments are there time is multiplied by 2 aand rate is divivded by 2
Nper=25years*2=50
Pmt=9%/2= 4.5% = 1000*4.5%= 45
PV=1187.66
FV=1000
Annual yield calculation
(1+3.6746%)^2-1
=7.4842%
After tax kd= 7.4842(1-40%)
=4.49%
Step4
Wacc when common equity from retained earnings
Wacc=W(ke)+W(Kd)+W(kp)
60%(16.42%)+30%(4.49%)+10%(7.69%)
11.97%
Step5
WACC when common equity from new stock
60%(12%)+30%(4.49%)+10%(7.69%)
9.32%
Step6
WACC is the cost of capital lower the wacc better it is
Therefore project with higher return should be selected as it will lead to higher value added
Return>WACC
Wacc higher than 11.97%
Is project A(13%) , B (12.5%), C(12%)
The above case is when WACC is when common equity is from retained earnings
In case where
common equity from new stock all the projects can be selected by big easy ltd
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